Distributing the Corporate Income Tax: Revused U.S ...

Office of Tax Analysis Technical Paper 5 May 2012

Distributing the Corporate Income Tax: Revised U.S. Treasury Methodology

Julie-Anne Cronin, Emily Y. Lin, Laura Power, and Michael Cooper

OTA Technical Papers is an occasional series of reports on the research, models and datasets developed to inform and improve Treasury's tax policy analysis. The papers are works in progress and subject to revision. Views and opinions expressed are those of the authors and do not necessarily represent official Treasury positions or policy. OTA Technical Papers are distributed in order to document OTA analytic methods and data and invite discussion and suggestions for revision and improvement. Comments are welcome and should be directed to the authors. OTA Papers may be quoted without additional permission.

DISTRIBUTING THE CORPORATE INCOME TAX: REVISED U.S. TREASURY METHODOLOGY

May 17, 2012

Julie Anne Cronin, Emily Y. Lin, Laura Power, and Michael Cooper

The purpose of this analysis is to improve the U.S. Treasury Department's distributional model and methodology by defining new model parameters. We compute the percentage of capital income attributable to normal versus supernormal return, the percentage of normal return attributable to a cash flow tax versus a "burdensome" capital tax, and the portion of the burdensome tax on normal return to capital to distribute to capital income versus to labor income. In summary, 82% of the corporate income tax burden is distributed to capital income and 18% is distributed to labor income. Keywords: distributional analysis, corporate tax incidence JEL Codes: H22, H25, D39

Julie Anne Cronin, U.S. Treasury Department, Washington D.C. USA (julie.anne.cronin@ ) Emily Y. Lin, U.S. Treasury Department, Washington D.C., USA (emily.lin@) Laura Power, U.S. Treasury Department, Washington D.C., USA (laura.power@) Michael Cooper, U.S. Treasury Department, Washington D.C., USA (michael.cooper@)

In 2008, the Office of Tax Analysis (OTA), U.S. Department of the Treasury revised its incidence assumption for the corporate income tax. Prior to 2008, OTA assumed the corporate income tax was borne entirely by all (positive) capital income.1 Currently, OTA assumes the share of the corporate income tax that represents a tax on supernormal returns is borne by supernormal capital income; the share of the corporate income tax that represents cash flow has no burden in the long run; and the remainder of the corporate income tax is borne equally by labor and positive normal capital income. In the final analysis the new methodology assumes 82 percent of the corporate tax burden is borne by supernormal or normal capital income and 18 percent is borne by labor.2

The change in distribution methodology was motivated by the desire to incorporate some of the more recent findings in the literature and to give Treasury the ability to more accurately capture the distributional effects of the existing tax system, which is a hybrid tax system that has features of a true income tax and of a consumption tax. Section I of this paper briefly reviews the literature. Section II summarizes the distribution assumptions of other tax policy offices. Section III gives a general description of our revised methodology. Section IV describes in detail how we used Treasury's Corporate Tax Model to measure the share of tax borne by supernormal returns and Section V describes how we used Treasury's Depreciation Model to measure the share of the corporate income tax that is not a burden in the long run. Section VI shows how the new assumptions affect the distribution of the corporate income tax, the distribution of certain proposed changes to the corporate income tax, and the distribution of all

1 Treasury had maintained this assumption since 1990, although some earlier Treasury studies took a shorter run view and distributed the corporate income tax to corporate shareholders. 2 The percentages used from 2008 through 2011 were 76 percent to normal or supernormal capital income and 24 percent to labor. These percentages were based on estimates by Gentry and Hubbard (1996) and Randolph (2006). Beginning with the 2012 model year, these percentages will be modified to reflect the findings presented in this paper.

federal taxes in general.

I. LITERATURE REVIEW

Harberger (1962) develops a general equilibrium model of corporate tax incidence where the economy is assumed to be closed and have two sectors, corporate and non-corporate. His analysis shows that, under certain assumptions, a tax increase on the return to corporate capital would be borne entirely by all owners of capital, including non-corporate capital. In equilibrium, the after-tax return to capital must be the same in the two sectors. Following this work, research has extended Harberger's model and modified its assumptions to draw additional conclusions about corporate tax incidence. Depending on the time frame and assumptions under consideration, some studies conclude that the incidence falls more narrowly on corporate capital whereas some studies show that the incidence falls more broadly beyond capital. Auerbach (2005) and Gravelle (2010) provide reviews of these studies.

As indicated in Harberger's model, the answer to the question of who bears the corporate tax incidence differs between the long run and the transition period. A corporate tax increase initially lowers the after-tax return to corporate capital, thereby reducing asset values through capitalization. In response, capital moves from the corporate to the non-corporate sector, reducing the pre-tax return to non-corporate capital. As capital flows take place, the corporate tax burden is shifted to non-corporate capital over time through reductions in the return to noncorporate capital until after tax returns in both sectors are the same. As such, the tax burden initially falls on current owners of corporate capital and then on future investors of corporate and non-corporate capital. Auerbach (2005) points out that this different timing of incidence has generational distribution implications because the change in asset values is felt instantly by older

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asset holders who have shorter planning horizons whereas the future change in the rate of returns will matter more for younger individuals who have not accumulated much wealth.

Another factor affecting the corporate tax incidence is investment and capital cost recovery provisions. The Harberger model assumes that the corporate income tax is imposed on economic income generated by corporate capital. In the presence of investment provisions such as accelerated depreciation, the corporate tax base deviates from economic income, resulting in a layer of corporate tax incidence not considered in the Harberger model. Auerbach (1983) shows that, because of the investment provisions, changes in corporate tax rates would alter the relative value of existing to new capital. This "surcharge" on existing assets imposes an additional piece of corporate tax incidence borne by existing shareholders during the transition period.

One critical assumption in Harberger's model is that the economy is closed. If capital owners have the ability to move capital abroad and escape the corporate tax increase, some burden of the higher tax will fall on domestic labor, which is assumed to be relatively immobile, through reductions in wages. The extent to which the burden is shifted to domestic labor depends on several factors. First, the less mobile the capital is across borders, the less burden is shifted to domestic labor as there will be less decline in the demand for domestic labor. Grubert and Mutti (1985) provide a simulation model demonstrating this relationship. In addition, the size of the U.S. capital stock relative to the rest of the world matters. As the United States is a large country, outflow of capital would lower the worldwide rate of return. This suggests that domestic capital cannot escape the corporate tax incidence entirely, leaving a smaller share of burden borne by domestic labor.

In the context of an open economy, the share of the corporate tax incidence borne by domestic labor depends also on the substitutability of the tradable goods and the degree to which

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the tradable goods are corporate capital intensive. If the tradable good is corporate capital intensive and there is perfect product substitution, then the incidence would fall relatively more on domestic labor as domestic capital can flow abroad to escape the tax. Randolph (2006) calibrates the effects with a simulation model where various assumptions are made about country size and the degree of capital intensity of corporate sectors. Gravelle and Smetters (2006) show that, in the long run, the extent to which the burden falls on domestic labor declines as foreign and domestic goods become imperfect substitutes.

Another factor not considered in the Harberger model is the type of return. Because the model assumes no risk and assumes competitive markets, it applies if capital earns a normal rate of return. Since the real, normal rate of return to capital is close to zero, Gordon (1985) suggests that the corporate income tax imposes little burden because the revenue collected reflects only the expected returns to risk. However, given that the corporate tax revenue is always positive, risk returns cannot be the only reason for the revenue collected. Depreciation allowances and limited loss offsets both contribute to explaining the positive tax revenue. Positive corporate tax revenues can also be a result of economic rents. Auerbach (2005) describes how the corporate tax incidence varies with the source of rents. In some cases the entire burden falls on corporate capital whereas in other cases the standard Harberger analysis applies.

Different types of returns to capital suggest that the corporate income tax revenue could be decomposed into one portion that is imposed on excess returns and the other portion on normal returns. Because normal returns to capital are exempt from tax under a consumption tax, several studies estimate the share of the corporate tax revenue attributable to normal returns to analyze the effect of switching from the current tax system to a consumption tax system. Gordon and Slemrod (1988), Gordon et al. (2004a), and Gordon et al. (2004b) estimate the effect of

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replacing the corporate income tax with a modified cash flow tax and find the revenue change sensitive to tax law and economic conditions. Toder and Rueben (2005) subsequently estimate the revenue effect of switching to expensing and find that the new tax base is equal to 68 percent of the corporate tax system in 2004, implying that normal returns are roughly 32 percent of all corporate returns. Using stock market data, Gentry and Hubbard (1996) estimate that a substantial portion ? about 60 percent ? of the return to corporate capital is in excess of the normal return.

II. ASSUMPTIONS BY OTHER TAX POLICY GROUPS

Government agencies and policy analysts have used different incidence assumptions to distribute corporate income taxes. From 1990 to 2008 Treasury assumed that the corporate income tax was born by all (positive) capital income. Cronin (1999) describes Treasury's distributional analysis methodology and Nunns (1995) illustrates the methodology with a distribution of the Omnibus Budget Reconciliation Act of 1993 (OBRA93). Since 1996 the Congressional Budget Office (CBO) has allocated the corporate income tax burden to capital income. The methodology is documented in several CBO papers and studies (1996, 1998, 2000, and 2011). From 1990 to 1995, CBO generally allocated half of the corporate income tax burden to labor income and half to capital income and this methodology was described in Kasten, Sammartino and Toder (1994). In its original tax burden study and its update, CBO (1987 and 1988) allocated the corporate tax burden in two ways, one in proportion to capital income and one in proportion to total labor compensation. The Joint Committee on Taxation has not distributed the corporate income tax since 1995 due to the uncertainty concerning the incidence of the tax. In distribution tables released for OBRA93 and its study, JCT (1993) distributed the

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burden to owners of corporate capital. The Urban-Brookings Tax Policy Center (TPC) has produced distribution tables since 2003 and during that time has allocated the corporate income tax to capital income. Browning and Johnson (1979) and Gale et al. (1996) allocate the corporate income tax to capital income, but show an alternative distribution where the tax is allocated to half labor and half capital income. Pechman (1987) assumes that the burden of the corporate income tax is borne by capital income.

III. GENERAL DESCRIPTION OF NEW METHODOLOGY

Treasury's new methodology has the goal of improving upon our prior methodology. We wanted to be able to model elements of expensing as the current corporate income tax is not a pure income tax. For example, some assets in service under the current corporate income tax have benefitted from accelerated depreciation. We also wanted to differentiate among proposals that affected only supernormal returns, only normal returns, or both types of returns. Under the prior methodology, a $10 billion dollar increase in the corporate income tax whether it represented an increase in burden on rents or a decrease in depreciation deductions had the same distribution. Any revenue-neutral change in burdens did not change the distribution. Under the new methodology (as illustrated below), an increase in burdens due to a rate increase is not distributed the same as an increase in burdens due to a decrease in depreciation deductions. A change in rates would affect the normal return to capital, labor and supernormal returns to capital while a change in depreciation deductions would only affect the normal return to capital and labor.

To improve our methodology, we have incorporated some of the findings in the literature including the observation that supernormal returns are taxed under a consumption tax while

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